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The Kentucky state workers’ pension system is by some measures the worst funded pension in the entire country with an estimated $70 billion dollars of unfunded liabilities. A recent audit of the pension system found that the plan has had $6.9 billion in negative cash flows since 2005.

At $40 billion, Kentucky teachers make up the largest portion of this unfunded liability. But even in the face of impending insolvency, many teachers in Kentucky are still protesting the slightest changes and cuts to their compensation that have been proposed in an effort to prevent catastrophe.

A minor reform bill recently signed into law that Governor Bevin admits “doesn’t come close” to solving the pension crises, and in no way changes current worker or past retiree’s pension or healthcare benefits, has been met with hysteria.

Many teachers and the Kentucky Education Association (KEA), the teacher’s union, are demanding the state raise revenue instead of cutting costs. The grand plan by the KEA and their lobby of teachers opposing pension reform is to take more money from those that are already responsible for paying teacher incomes - the Kentucky taxpayer. Instead of making concessions in an effort to fix their own underlying problem, they want a bailout. Not only would such a bailout set a very dangerous precedent, but for reasons I will explore below, it would be economically disastrous for Kentucky’s economy and private sector.

To put the $70 billion of unfunded pension liabilities in perspective, Standard & Poor's has ranked Kentucky's public pension as the worst-funded of any state in the US, with just 37.4 percent of the money it needs to pay obligations to retirees.Moody's has ranked Kentucky as having the third-highest pension debt when measured against a state's capacity to pay it off. With just over $10 Billion in total annual tax revenue for Kentucky’s General Fund, every state run institution and service in Kentucky would need to close for nearly 7 years just to fund past pension liabilities.

But despite this fact, the KEA and supporting teachers still insist that the state can somehow tax its way to solvency.

How Did We Get Here? The Moral Hazard of an “Inviolable Contract”

Over the past 30 years, and particularly in periods of unsustainable stock market booms, politicians from across the country sweetened government employee compensation packages by making ill-conceived promises. These promises, largely in the form of defined benefit pensions and health insurance, relied on market investments performing at levels that were wholly unrealistic. Kentucky was one such state, requiring a consistent near 8% rate of return annually to stay solvent. The problem was not, as the KEA and its supporters would have you believe, politicians using the money nefariously. In fact, the official audit of the pension plan stated that 23 percent of the growth in unfunded liabilities was due to the market underperforming the assumed rate of return. An additional 47 percent of the shortfall was found to be a result of making unrealistic actuarial assumptions and negative amortization caused by making inaccurate forecasts for state payroll growth. In layman’s terms, the financial assumptions made when projecting the plan’s ability to pay out were simply out of touch with reality.

In recent weeks Kentucky teachers have been calling in sick to hold protest rallies at the state capital, effectively striking, while entire school districts are forced to shut down. They condemn any cuts to their retirement benefits as a “broken promise.” Not only should the state honor their promise they say, but they must given that these benefits are part of an “inviolable contract.” So what is this magic “inviolable contract” that guarantees future payment despite having no money to pay out? Essentially, this “contract” is nothing more than a state decree supposedly guaranteeing public worker benefits no matter the financial circumstance. Which is, of course, an astoundingly ignorant economic proposition. As the saying goes, you cannot draw blood from a turnip.

With this problem growing for well over a decade, why then are teachers, the KEA, and politicians just now confronting the problem? The answer is quite simple: economic moral hazard. Neither the politician nor the teachers have any skin in the game. The creation of an “inviolable contract” which puts future taxpayers on the hook for promises made by past politicians is practically the textbook definition of an economic moral hazard. An “inviolable contract” with the state is a promise by politicians that government will extort whatever amount of income necessary from those in the private sector to make government workers whole. In this arrangement there is no incentive for teachers to keep an eye on the health of their own retirement. Why would a pensioner care to keep up with and address the problems as they have unfolded over the past decade if they are guaranteed government protection from the fallout? Obviously they would not and they did not. It was not until Governor Bevin was elected and began speaking honestly about the necessary budget cuts that teachers were impelled to action.

Beyond the simple fact that they are often years removed from political office before their grand plans turn into grand catastrophes, economics also explains why politicians make such unrealistic promises. The lesson is one of concentrated benefits and disperse costs. That is to say, a promise to teachers and state workers to sweeten their terms of employment is sure to gain the support of a large state worker voting pool. Meanwhile, the taxpayer which is busy trying to make a living in their respective field, has little time to assess and weigh in on such matters. In fact, up and to a point, the cost of engaging in this political process is more costly to the taxpayer than just forking over their additional portion in tax money to the lobby.

The Underpaid Kentucky Public Teacher Myth

More recently, teachers have begun not only protesting any changes to their retirement benefits, but also bringing attention to their claim that they are not paid fairly. Economically speaking, one could never actually know what the fair market value is for an employment arrangement that is forced upon the ‘buyer’ of the service, as is the case with public education. This claim also shows the KEA and supporting teacher’s unwillingness or inability to assess the value of their total compensation. After all, retirement benefits, hours worked, vacation days and salary must all be considered when honestly discussing compensation.

Based on Fidelity Financial’s retirement planning tool, an individual that works 27 years before retirement (the threshold for Kentucky teachers), earning an average $50,000 per year over the period, and that contributes to their retirement at the rate of Kentucky teachers (just over 9%) could only hope to have a yearly payout of just over $10,600 in retirement. When you compare this to the average Kentucky teacher pension distribution in retirement of $36,000 per year, it is clear that teachers are contributing very little to their own retirements and are compensated extremely well by taxpayers. If a teacher retires at age 55 and lives until age 85, this puts the taxpayers of Kentucky on the hook for $762,000 per teacher in retirement alone. This claim of “unfair pay” is especially suspect given that teachers in private schools average significantly lower incomes in terms of both salary and total compensation.

That said, Kentucky teachers do not do themselves any favor by bringing attention to even the salary portions of their compensation. Public teachers in the state, when adjusted for cost of living, are the seventh best paid public teachers of any state in the US with an average salary of over $52,000 per year. When you consider that Kentucky teachers work a total of 185 days, or just half the year, the figure is even more impressive. Put in terms of hourly compensation, Kentucky teachers earn roughly double that of the average worker in the state. This salary is even more staggering when put in perspective of the taxpayers of Kentucky’s ability to pay: Kentucky ranks 47th in the country for worker incomes, with a median income of $43,000 per year. This enormous disparity is undoubtedly unknown by the majority of Kentucky voters and taxpayers that succumb to the teacher’s emotional appeals of being shortchanged.

Moving Forward

Kentucky is currently ranked 33’rd of all states in the Tax Foundation’s Business Tax Climate Index, while neighboring Indiana is ranked 9th and Tennessee is ranked 14th. The only adjoining state to have a less attractive tax policy is Ohio. The KEA, teachers, and politicians coming to their defense are proposing to make the state even less competitive with our neighbors by advising to increase tax revenues instead of cutting costs. Not only would such a policy only serve to cover over the fundamental problem of making financial promises in retirement that are out of line with economic reality, but this sort of policy prescription puts the health of the entire state economy at risk. Individuals and businesses respond to higher taxes - they buy less, move here less, expand less, and hire fewer people. This is the underlying reason why simply raising tax rates does not always create more tax revenue, as people and companies move to more tax friendly states and avoid taxable activities. For those that think this is economic hyperbole or purely theory, just look to our neighbors in Illinois. The recent fallout from such policy folly has ultimately led to an exodus from the state.

If Kentucky is to prevent economic catastrophe and keep checks flowing to current retirees it can only be done by dramatically slashing spending and transitioning new and current teachers to a more private-sector-like compensation plan. Working for state government cannot both be more profitable than working in the private sector while also coming with zero risk of losing your job, having your pay cut or benefits renegotiated. Suggesting otherwise not only makes a mockery of the often referred to “public servant” but suggests that a young college graduate would be foolish to entertain work in the private sector that comes with far fewer benefits and far greater risks. The KEA and teachers unwilling to see cuts to their benefits are ultimately setting the stage for a long drawn out economic failure similar to that seen in Illinois, where individuals and businesses leave the state creating an ever smaller need for teachers and ever smaller pool of tax revenue. It is imperative to remember that the success of the private sector precedes the ability to have any employment in the public sector at all.